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The Best Stocks in Conglomerates

The word "conglomerate" often comes with negative connotations, but these companies seem to make it work -- more often than not, anyway

Conglomerates go in and out of favor, with periods of mergers juxtaposed against periods of divestitures. However, there are a few names in the space that seem to make the idea of putting often disparate businesses under one roof work. The biggest and best known is probably Berkshire Hathaway(NYSE:BRK-B). Another name to look at is Johnson & Johnson(NYSE:JNJ), a long successful collection of businesses that you may not think of as a conglomerate. But before you search for the best stocks in conglomerates, it's worth considering the trials and tribulations of General Electric Company(NYSE:GE), a conglomerate that's slowly mending itself after getting overextended in the finance sector.

Lost in the financesAt one point in time, General Electric was held up as a success story in the world of conglomerates. It owned a television station and industrial businesses, and it had a successful finance arm among many other things. The problem was that profits at its finance arm were huge, so GE started to let that business grow. And grow. And grow. Doing that, however, took the company further and further away from the original point of its finance arm, which was to help finance the sale of its own products.

GE's famous logo. Source: General Electric Company.

When the 2007-to-2009 finance-led recession hit, GE's finance business took a huge hit. Lured by big profits, the company went too far in one direction and wound up paying a huge price, including a steep price decline, a dividend cut, and a government bailout. This is a story worth remembering, because all conglomerates have to deal with similar temptations.

Oddly enough, GE is now getting back to basics, shedding businesses, most notably in its finance division, that don't fit with its industrial focus. For investors seeking a turnaround play in the conglomerate space, it may be worth a look. The problem is that the transformation taking place makes the company's top and bottom lines hard to read. But what isn't hard to see is that the dividend is, once again, on the growth track, increasing in each of the last five calendar years (including 2015). That's a strong sign that management sees bright things ahead.

The ConglomeratorShifting gears to conglomerate success stories, many would argue that Berkshire Hathaway, led by Warren Buffett, is one of the greatest companies ever created. Based on the incredible returns long-term investors have seen, there's a strong case to be made. But what makes Berkshire so interesting is really the disparate nature of its holdings, which range from power utilities to trains to insurance to auto dealerships. There's a whole lot more in between, too.

The thing that sets Berkshire Hathaway apart, however, is the way in which it cobbles this collection of companies together. Essentially, the heads of each individual business are expected to run their operations as they see fit, with Berkshire operating as a protective umbrella and, often, a source of growth capital. That means each business can take a long-term view, without having to worry about pleasing Wall Street every quarter. Buffett keeps tabs on how things are going, of course, but he doesn't tell people how to do their jobs. He just tries to make sure he partners up with trustworthy people who are good at what they do.

While it's hard to predict when Berkshire will make its next big deal to boost the top- and bottom-lines, the company's long history of successful acquisitions suggests there's more to come. That and the over $60 billion of cash the company had sitting on the balance sheet at the end of the second quarter.

In the end, Berkshire is almost like a giant mutual fund or a private-equity shop, only it's set up as a company. The company's success, however, is far from a secret, and the shares usually trade at a premium. Which makes sense for a company that has seen its share price increase, on average, over 20% a year between 1965 and 2014, a period over which the S&P 500 Index was able to advance at less than half that rate. If you're looking for the best stocks in conglomerates, this is one name you have to examine, even if the goal is only to see a successful conglomerate structure in action.

A focused conglomerate Another name that's had great success in the conglomerate space may be one that you wouldn't think of as a conglomerate: Johnson & Johnson. Yes, it is a medical company. But it's a collection of businesses when you break it down. Right now, it has operations in consumer products, drugs, and medical devices. That list has ebbed and flowed over time, and there are multiple companies contained in each of these categories.

Band-Aid, one of the many brands owned by J&J. Source: Johnson & Johnson.

With all of its eggs in the healthcare basket, however, it would be fair to question why I've called it a conglomerate. The reason is the way it's run. Like Berkshire Hathaway, Johnson & Johnson manages the strategic direction of the company and allocates resources to its various subsidiaries, each of which essentially operates on its own. So it really is a healthcare conglomerate.

The company's top line fell during the 2007 to 2009 recession, which isn't surprising, but revenues have been growing fairly steadily since 2010. Earnings, meanwhile, are roughly 50% higher than they were before the recession hit. And while the downturn was an issue, Johnson & Johnson was never at risk of bleeding red ink. Healthcare, as you might expect, tends to hold up well in bad times since acquiring the proper medical care isn't really an optional expense.

Moreover, with decades of annual dividend increases under its belt, it's a solid option for income investors interested in conglomerates. Berkshire doesn't pay a dividend, and, as noted, GE cut its dividend as part of its turnaround effort (though, to be fair, GE's dividend is starting to grow again).

Good or bad?So GE shows that there are reasons to be concerned about conglomerates. And even giant Berkshire Hathaway has made mistakes over the years (Berkshire Hathaway, for example, was originally a textile manufacturer whose business succumbed to foreign competition under Buffett's watch). But when done well, conglomerates can produce results that highly focused companies don't always achieve. And Berkshire Hathaway is, perhaps, the best example, with its market returns speaking volumes about the efficacy of its approach. However, don't think a conglomerate has to be as diversified as Berkshire to make the model work -- which is why recovering GE is worth looking into and long successful Johnson & Johnson and its steadily rising dividends is, too.

Reuben Brewer has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Berkshire Hathaway. The Motley Fool owns shares of General Electric Company. The Motley Fool recommends Johnson & Johnson. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.